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Do Treasury Yields Matter When Valuing Equities?


Viking
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Zero Hedge posted a very interesting August commentary by GMI... looks to me like it summarizes very well the bear case. I also enjoy reading John Hussman very much (I like the logic he presents...) and he is also quite pessimistic about equity valuations.

 

http://www.zerohedge.com/article/gmi-describes-future-recession-ongoing-depression-must-read-report

 

I have a question I am having a hard time answering. Should current treasury yields factor into how one values equities? Today I can buy well run companies with low debt, solid moats and reasonable growth prospects (8 to 10%) at 12 to 14 times current year net earnings. However in the 1980's these kind of companies were trading at 8 times earnings (or less). My question is inflation in the 1980's was running at double digit levels and Treasury yields were also double digit whereas today inflation and Treasury yields are crazy low... If inflation/Treasury yields are a key factor when valuing stocks then perhaps equities are chaper today than people think???

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Zero Hedge posted a very interesting August commentary by GMI... looks to me like it summarizes very well the bear case. I also enjoy reading John Hussman very much (I like the logic he presents...) and he is also quite pessimistic about equity valuations.

 

http://www.zerohedge.com/article/gmi-describes-future-recession-ongoing-depression-must-read-report

 

I have a question I am having a hard time answering. Should current treasury yields factor into how one values equities? Today I can buy well run companies with low debt, solid moats and reasonable growth prospects (8 to 10%) at 12 to 14 times current year net earnings. However in the 1980's these kind of companies were trading at 8 times earnings (or less). My question is inflation in the 1980's was running at double digit levels and Treasury yields were also double digit whereas today inflation and Treasury yields are crazy low... If inflation/Treasury yields are a key factor when valuing stocks then perhaps equities are chaper today than people think???

 

 

Yes, they are, but US taxes are set to increase at the end of the year, especially the dividend tax rate.   High income people will sell off assets to pay taxes for the once in a lifetime conversion Of IRA's and 401k's to Roth IRA's.  The market will tank when that happens, unless there is a big change in the escalating rates, a change that now looks increasing unlikely.

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I have a question I am having a hard time answering. Should current treasury yields factor into how one values equities? Today I can buy well run companies with low debt, solid moats and reasonable growth prospects (8 to 10%) at 12 to 14 times current year net earnings. However in the 1980's these kind of companies were trading at 8 times earnings (or less). My question is inflation in the 1980's was running at double digit levels and Treasury yields were also double digit whereas today inflation and Treasury yields are crazy low... If inflation/Treasury yields are a key factor when valuing stocks then perhaps equities are chaper today than people think???

 

The question is, do real returns matter?

 

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I always believed that comparing earnings yield and treasury yields is a dangerous game. This is a recent creation made popular by Greenspan. It may appear to make sense at a given moment, but things change rapidly and once you have made your investment, you are locked in.

 

If you look back in history, you will find that it was more dividend yields being compared with treasury yields and other bonds (Intelligent Investor for example). They were basically comparing the money that goes directly into your pocket following the investment. There was a lack of trust on reinvested earnings which I think is fair. If it worked out well, it was the cream on the top or the reward for taking the additional risk.

 

The way I look at it, low treasury yields should help corporations refinance with bonds at lower rates. At the same time, low treasury yields indicate a low growth economy meaning fewer opportunities, excess capacity and more competition. This means lower growth rates and more chances for managers to poorly allocate reinvested earnings.

 

If you were starting up a business, what kind of return would you demand? Would you settle for a 6 or 7% rate of return because 10 year treasury yields are just below 3%? IMO, you would likely demand a minimum 10% for the effort and risk that you are getting into.

 

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I have a question I am having a hard time answering. Should current treasury yields factor into how one values equities? Today I can buy well run companies with low debt, solid moats and reasonable growth prospects (8 to 10%) at 12 to 14 times current year net earnings. However in the 1980's these kind of companies were trading at 8 times earnings (or less). My question is inflation in the 1980's was running at double digit levels and Treasury yields were also double digit whereas today inflation and Treasury yields are crazy low... If inflation/Treasury yields are a key factor when valuing stocks then perhaps equities are chaper today than people think???

 

The question is, do real returns matter?

 

 

 

Yes.  Very much, according to Ron Muhlenkamp in his book, Harvesting Profits on Wall Street.  He makes a strong case that the Fed Model is deeply flawed, and that the strong correlation is between real interest rates and company profits/stock market returns.

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I view the  long term Treasury yield as the "risk free rate". As noted this can change quickly, usually I believe on the perception of future value of money (i.e. the amount inflation)...I think one would do well with companies that can increase the prices to keep up with or stay ahead of inflation ...

 

Companies look cheaper because Mr Market believes inflation will be low in the future, whereas in the 80's Mr Market was expecting higher inflation.

 

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